Global Risk Reappears, Bonds Benefit

Geopolitical risk flared anew last week, and government bonds were the big beneficiaries, forestalling yet again the long-anticipated rise in Treasury yields.

Thursday's combination of a Malaysian airliner being shot down in Ukraine near the Russian border, and an Israeli ground invasion of Gaza, sent investors herding into reliable havens. Yields on German, French, Austrian, and Belgian 10-year bonds hit record lows, per Bloomberg data, while the 10-year Treasury yield fell to 2.44%, near a 13-month low.

Recall that the 10-year Treasury yield began 2014 at 3%, up from 1.64% in May 2013, and just about everyone expected it to keep rising. Not only did it fall, instead, but it has repeatedly refused to rebound, even amid incoming data that show a gradually improving U.S. economy, coupled with a Federal Reserve that's ending its bond-buying program and is expected to start raising its short-term policy rate a year from now.

LAST WEEK ALSO BROUGHT confirmation of another reason yields won't rise: China keeps buying Treasuries. Two weeks ago, I wrote on that subject in this column, and on Wednesday, the latest Treasury Department data showed that China had upped its holdings of Treasuries by $107 billion during this year's first five months, to $1.27 trillion, just under 11% of Treasury debt outstanding.

The fact that rates remain so low, even as the U.S. economy is healing, doesn't sit well with some people, who feel this keeps encouraging investors to take on riskier investments. James Bullard, president of the Federal Reserve Bank of St. Louis, on Thursday said there's a "mismatch" between current Fed policy and the state of the economy, saying if economic conditions keep improving at the current pace, the Fed might need to raise rates sooner than expected.

Duquense Capital founder Stanley Druckenmiller, speaking at last week's Delivering Alpha conference, had harsher words. "We are at once-in-a-century emergency levels" for interest rates, he said, but "we're probably at the 40th percentile" of long-term economic performance. He sees the continuation of crisis-era Fed policy as "not only unnecessary but fraught with unappreciated risk," adding that neither the Fed nor anybody else knows how things will end.

Among current pockets of risk, as I've warned in this column before, is the corporate bond market. Not only are corporates rich, but they can also be harder to sell than they were just a few years ago. Since the financial crisis, banks have cut their corporate-bond holdings to keep pace with regulations. Inventory is down by 40% to 75%, according to various estimates, and if there's ever a rush to sell, fewer willing buyers could mean steeper losses, affecting bonds, mutual funds, and ETFs alike.

"THERE'S NO QUESTION that liquidity has decreased," says Gershon Distenfeld, director of high yield at AllianceBernstein, who says increased capital requirements have curtailed risk appetite among banks and dealers and made it more costly to maintain bond inventories. He adds that Bear Stearns, Lehman Brothers, and Merrill Lynch used to represent more than a third of U.S. high-yield trading volume, and none of them exist as a stand-alone entity today.

Fixed-income trading at banks "is evaporating," says James Swanson, chief investment strategist at MFS Investment Management. He sees corporate bonds, particularly high yield, as increasingly perilous for investors. "Are those markets, given how low yields are, compensating you for the risk of illiquidity?"

Corporate bonds are often pulled in two directions: When equity prices fell amid last week's turmoil, riskier corporates slid, too, but the losses were tempered by gains in underlying Treasury bonds. That pattern can hold up for short periods but will be challenged during more protracted downturns, especially if nobody really wants to buy.

Correction: An earlier version of this column misstated the year that began with the 10-Year Treasury bond yielding 3%. It was 2014.

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